Taxes on Roth IRA withdrawals

They’re not always income-tax-free; here’s what you need to know

By

BillBischoff

If you own a Roth IRA, you may be under the impression that withdrawals are always income-tax-free. Not true. Even worse, some withdrawals can be socked with a 10% penalty on top of the income tax bill. Here’s what you need to know if you took some Roth withdrawals last year.

The simplest case

If you’re 59½ or older and have had at least one Roth IRA open for over five years, withdrawals from any of your Roth IRAs are qualified withdrawals. As such, they are free of any federal income tax or penalty. The five-year period for qualified withdrawals starts on January 1 of the first tax year for which you make a Roth contribution.

Example 1: You established your first Roth IRA with a regular annual contribution on April 15, 2009. The contribution was for the 2008 tax year. Your five-year period started on Jan. 1, 2008 even though the contribution was actually made in 2009. Anytime after Jan. 1, 2013, you can take tax-free qualified withdrawals from any and all Roth IRAs that you own — as long as you’re 59½ or older. For instance, say you opened a second Roth account in 2012 by converting a traditional IRA. You can take tax-free qualified withdrawals from that account too anytime after Jan. 1, 2013 — as long as you’re at least 59½ at the time.

More complicated cases

Scenario 1: You’re under 59½

Any Roth withdrawal taken before 59½ is a nonqualified withdrawal. As such, it’s potentially (but not necessarily) subject to federal income tax and a 10% penalty tax. Here’s how nonqualified withdrawals are treated in this scenario.

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* Nonqualified withdrawals are deemed to come first from the layer consisting of annual Roth contributions. Withdrawals from this layer are always tax-free and penalty-free. To figure out how much is in this layer, add up annual contributions to all Roth IRAs set up in your name (ignore any accounts in your spouse’s name). To prove you don’t owe any income tax or penalty, fill out Part III of IRS Form 8606 (Nondeductible IRAs) and file it with your Form 1040.

* Next, nonqualified withdrawals are deemed to come from the layer consisting of Roth conversion contributions, if any. These are contributions from converting a traditional IRA into a Roth or from contributing a retirement plan payout (like from a 401(k) plan) to a Roth. To figure out how much is in this layer, add up all conversion contributions to all Roth IRAs set up in your name (ignore any accounts in your spouse’s name). Withdrawals from this layer are federal-income-tax-free, but you could still get hit with a 10% penalty tax. To prove you don’t owe any income tax, fill out Part III of Form 8606. The 10% penalty tax applies unless: (1) the conversion contribution was more than five years before the withdrawal date (the five-year period starts on January 1 of the year when the conversion contribution occurred) or (2) you’re eligible for an exception. (For a list of the exceptions, see How to make penalty-free IRA withdrawals.) If you owe the penalty tax, fill out IRS Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Plans) and enter the penalty on line 58 of Form 1040.

* Finally, any further nonqualified withdrawals from Roth accounts set up in your name (after you’ve sucked out all your contributions) are deemed to come from the layer consisting of Roth IRA earnings. Nonqualified withdrawals from this layer are 100% taxable. Fill out Part III of Form 8606 to calculate the taxable amount from this layer, and enter that figure on Line 15b of Form 1040. In addition, the 10% penalty tax applies to nonqualified withdrawals taken from this layer unless you’re eligible for an exception. (For a list of the exceptions, see How to make penalty-free IRA withdrawals.) If you owe the penalty tax, fill out Form 5329 and enter the penalty on line 58 of Form 1040.

Scenario 2: You fail the five-year test

Any Roth withdrawal taken before passing the five-year test is also a nonqualified withdrawal. As such, it’s potentially (but not necessarily) subject to income tax and a 10% penalty tax. In this scenario, nonqualified withdrawals are generally handled under the same three-layer system that applies to Scenario 1. Most importantly, nonqualified withdrawals from layer 3 are 100% taxable. Fill out Part III of Form 8606 to calculate the taxable amount from layer 3, and enter that figure on Line 15b of Form 1040.

The only difference in this scenario is you’re never hit with the 10% penalty tax on withdrawals taken after reaching age 59½. If you’re younger, however, the penalty tax will bite unless you’re eligible for an exception. (For a list of the exceptions, see How to make penalty-free IRA withdrawals.) If you owe the penalty tax, fill out Form 5329 and enter the penalty on line 58 of Form 1040.

Scenario 3: You qualify for special home purchase exception

If you’ve passed the five-year test but you’re under 59½, a special exception allows tax-free and penalty-free Roth withdrawals to the extent of money spent within 120 days to buy a principal residence. However, there’s a lifetime $10,000 limit on this deal. The home buyer can be you or certain relatives (including kids and grandkids). However, the buyer must not have owned a principal residence within the two-year period ending on the purchase date.

The last word

While the tax rules for nonqualified Roth withdrawals are complicated, everything falls in place when you complete Part III of Form 8606. One more thing: shortly after the end of any year you take withdrawals, you should receive a Form 1099-R from the Roth trustee or custodian. It shows the total amount of withdrawals for the preceding year, and the IRS gets a copy. So if you took any nonqualified withdrawals, the Feds will expect to see a Form 8606 included with your return.

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